Financial markets have been beset by an assortment of issues in 2015. The manufacturing sector slowed, Chinese growth weakened, commodity prices fell, deflation concerns persisted and geopolitical risks grew. Given this backdrop, it would hardly be surprising to see equities and other risk assets lagging, but they are not. Enough counterbalancing factors (including low inflation, decent U.S. economic growth and supportive monetary policy) have allowed U.S. equity markets to post modest gains so far this year.
But how long will this continue? We believe the investment landscape is poised to undergo significant changes next year. The effects of the long-term rise of the value of the U.S. dollar and corresponding decline in commodity prices should begin to fade. At the same time, headline inflation should begin to advance as the global economy gains some momentum.
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TIGHTENING PHASE
And, of course, the Federal Reserve is likely to be at the start of a tightening phase. Although we expect rate increases to be slow and modest, it is important to remember that it has been nearly a decade since the Fed raised rates. As such, it will likely take some time for investors to determine how to respond, which could contribute to volatility.
Given these changes, it is fairly easy to make a bearish argument for U.S. equities: U.S. financial conditions are tightening and corporate profits are struggling. Many companies are starting to see lower levels of free cash flow, which could mean reduced corporate buybacks. And without repurchasing activity, higher revenues and sales would be required to produce earnings gains. Yet, the revenue outlook is troubled, thanks to the ongoing strength of the U.S. dollar.
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We think this view is overly negative. The risks of a global recession appear low, and we think the world economy is more likely to accelerate rather than slow next year. The pockets of economic weakness that occurred in 2015 were concentrated in manufacturing and in emerging markets, which were linked with the collapse in oil prices.
CONTINUED ACCELERATION
Our moderately constructive outlook is predicated on our expectations for a continued acceleration in U.S. growth, a recovery in the eurozone and stabilizing growth in China. We expect such an environment will mean increases in both equity prices and government bond yields. As such, we expect equities will outperform bonds over the next six to 12 months, although the ride is likely to be bumpy.
Bob Doll is senior portfolio manager and chief equity strategist at Nuveen Asset Management. This commentary originally appeared on his blog.
